Banks operate in a highly regulated system where they must conform to the standards of the regulatory bodies. These standards require them to assess risk in a pretty standard way, relying on financial statements prepared by the borrower or an accountant. So a bank will create a Loan Grading System or Policy which conforms to those requirements.

The three major factors in assessing loan risk are: Cash Flow, Liquidity and Leverage. Trends in these factors are important as well.

Cash Flow is calculated in a simple way and then there are more complex ways to calculate cash flow. We will only discuss the simple way. A bank will determine "Cash Flow Available for Debt Service" according to this formula. Pretax Net Income, plus Depreciation Expense, Plus Interest Expense, less Federal Income Taxes or in the case of different business types, Owner Withdrawals (required to pay income taxes personally on the business income).

This Cash Flow will then be compared to the Annual Debt Service of the business to calculate a Debt Service Coverage ratio. Normally a bank will want a minimum of 1.2:1. If this is the case and the balance sheet is healthy the loan will be considered a "Pass" and the bank will not be required to set aside additional Capital or Loan Loss Reserves against that loan. If the Debt Service Coverage is less than 1:1 the loan will often be "Classified" and will become a problem for the bank.

In more sophisticated grading systems the better the financial ratios, the better the risk grade even within "Pass" categories. The bank will be able to set aside less capital against these loans and will therefore be able to price them lower and earn the same Return on Equity.

There is no problem when a business owner uses accelerated depreciation to reduce Net Income and lower the tax burden. The problems for the bank crop up when the owner decides to:

1. Pay high salaries or bonuses at year end to reduce net income
2. Write off inventory or accounts receivable that are still collectable in order to reduce net income
3. Not report revenues at year and and carry them over into the following year by not depositing checks that have come in.
4 Prepaying expenses for the following year without accruing them as an asset (Prepaids)
5. Otherwise make accounting entries to reduce Net Income to a level that is not reflective of the true economic performance of the business.

Some of these strategies may create problems with the IRS at some future date as well.

The impact on the bank is that the Cash Flow Available For Debt Service number will drop suddenly (compared to interim statements), the Debt Service Coverage Ratio may go negative, and the Trends will be negative. The borrower may lose access to credit or have to borrow on more restrictive or more expensive terms. This may restrict the growth prospects of the business and create an Opportunity Cost that is greater than the tax savings. It will also impact the relationship with the bank and banker.

These same strategies can have a negative impact on the Balance Sheet and create similar issues. Liquidity can be understated if assets are no reported. Leverage will increase. Collateral values can be under reported and can create problems with a Borrowing Base or a Loan to Value ratio.

Once again these balance sheet impacts may cause a bank to assess higher risk to the credit and reduce the availability of loan funds or increase borrowing costs or restrictions.

My bottom line advice is this, before employing some of these tax strategies determine what their impact will be on your reported cash flow. Talk to your banker in addition to your accountant. Determine what your future borrowing needs might be and how these might impact a loan application. Here is a critical point. The bank will generally use your historical cash flow and will compare it to your future debt service. So when you are going to apply for new debt, the Debt Service used in the denominator of the formula will include that debt. It will be compared to

This Cash Flow will then be compared to the Annual Debt Service of the business to calculate a Debt Service Coverage ratio. Normally a bank will want a minimum of 1.2:1. If this is the case and the balance sheet is healthy the loan will be considered a "Pass" and the bank will not be required to set aside additional Capital or Loan Loss Reserves against that loan. If the Debt Service Coverage is less than 1:1 the loan will often be "Classified" and will become a problem for the bank.

In more sophisticated grading systems the better the financial ratios, the better the risk grade even within "Pass" categories. The bank will be able to set aside less capital against these loans and will therefore be able to price them lower and earn the same Return on Equity.

There is no problem when a business owner uses accelerated depreciation to reduce Net Income and lower the tax burden. The problems for the bank crop up when the owner decides to:

1. Pay high salaries or bonuses at year end to reduce net income
2. Write off inventory or accounts receivable that are still collectable in order to reduce net income
3. Not report revenues at year and and carry them over into the following year by not depositing checks that have come in.
4 Prepaying expenses for the following year without accruing them as an asset (Prepaids)
5. Otherwise make accounting entries to reduce Net Income to a level that is not reflective of the true economic performance of the business.

Some of these strategies may create problems with the IRS at some future date as well.

The impact on the bank is that the Cash Flow Available For Debt Service number will drop suddenly (compared to interim statements), the Debt Service Coverage Ratio may go negative, and the Trends will be negative. The borrower may lose access to credit or have to borrow on more restrictive or more expensive terms. This may restrict the growth prospects of the business and create an Opportunity Cost that is greater than the tax savings. It will also impact the relationship with the bank and banker.

These same strategies can have a negative impact on the Balance Sheet and create similar issues. Liquidity can be understated if assets are no reported. Leverage will increase. Collateral values can be under reported and can create problems with a Borrowing Base or a Loan to Value ratio.

Once again these balance sheet impacts may cause a bank to assess higher risk to the credit and reduce the availability of loan funds or increase borrowing costs or restrictions.

My bottom line advice is this, before employing some of these tax strategies determine what their impact will be on your reported cash flow. Talk to your banker in addition to your accountant. Determine what your future borrowing needs might be and how these might impact a loan application. Here is a critical point. The bank will generally use your historical cash flow and will compare it to your future debt service. So when you are going to apply for new debt, the Debt Service used in the denominator of the formula will include that debt. It will be compared to

There is no problem when a business owner uses accelerated depreciation to reduce Net Income and lower the tax burden. The problems for the bank crop up when the owner decides to:

1. Pay high salaries or bonuses at year end to reduce net income
2. Write off inventory or accounts receivable that are still collectable in order to reduce net income
3. Not report revenues at year and and carry them over into the following year by not depositing checks that have come in.
4 Prepaying expenses for the following year without accruing them as an asset (Prepaids)
5. Otherwise make accounting entries to reduce Net Income to a level that is not reflective of the true economic performance of the business.

Some of these strategies may create problems with the IRS at some future date as well.

The impact on the bank is that the Cash Flow Available For Debt Service number will drop suddenly (compared to interim statements), the Debt Service Coverage Ratio may go negative, and the Trends will be negative. The borrower may lose access to credit or have to borrow on more restrictive or more expensive terms. This may restrict the growth prospects of the business and create an Opportunity Cost that is greater than the tax savings. It will also impact the relationship with the bank and banker.

These same strategies can have a negative impact on the Balance Sheet and create similar issues. Liquidity can be understated if assets are no reported. Leverage will increase. Collateral values can be under reported and can create problems with a Borrowing Base or a Loan to Value ratio.

Once again these balance sheet impacts may cause a bank to assess higher risk to the credit and reduce the availability of loan funds or increase borrowing costs or restrictions.

My bottom line advice is this, before employing some of these tax strategies determine what their impact will be on your reported cash flow. Talk to your banker in addition to your accountant. Determine what your future borrowing needs might be and how these might impact a loan application. Here is a critical point. The bank will generally use your historical cash flow and will compare it to your future debt service. So when you are going to apply for new debt, the Debt Service used in the denominator of the formula will include that debt. It will be compared to

Some of these strategies may create problems with the IRS at some future date as well.

The impact on the bank is that the Cash Flow Available For Debt Service number will drop suddenly (compared to interim statements), the Debt Service Coverage Ratio may go negative, and the Trends will be negative. The borrower may lose access to credit or have to borrow on more restrictive or more expensive terms. This may restrict the growth prospects of the business and create an Opportunity Cost that is greater than the tax savings. It will also impact the relationship with the bank and banker.

These same strategies can have a negative impact on the Balance Sheet and create similar issues. Liquidity can be understated if assets are no reported. Leverage will increase. Collateral values can be under reported and can create problems with a Borrowing Base or a Loan to Value ratio.

Once again these balance sheet impacts may cause a bank to assess higher risk to the credit and reduce the availability of loan funds or increase borrowing costs or restrictions.

My bottom line advice is this, before employing some of these tax strategies determine what their impact will be on your reported cash flow. Talk to your banker in addition to your accountant. Determine what your future borrowing needs might be and how these might impact a loan application. Here is a critical point. The bank will generally use your historical cash flow and will compare it to your future debt service. So when you are going to apply for new debt, the Debt Service used in the denominator of the formula will include that debt. It will be compared to

Once again these balance sheet impacts may cause a bank to assess higher risk to the credit and reduce the availability of loan funds or increase borrowing costs or restrictions.

My bottom line advice is this, before employing some of these tax strategies determine what their impact will be on your reported cash flow. Talk to your banker in addition to your accountant. Determine what your future borrowing needs might be and how these might impact a loan application. Here is a critical point. The bank will generally use your historical cash flow and will compare it to your future debt service. So when you are going to apply for new debt, the Debt Service used in the denominator of the formula will include that debt. It will be compared to your historical cash flow. So while you may have had an acceptable Debt Service Coverage ratio based on your current debt, when you add the new debt service it is below the bank's standards and you may either be denied, your borrowing rates may go up, or more restrictions may be added as conditions of the loan.